3/18/2009 @ 12:00PM

The ABCs Of Child Care Breaks

Everyone now knows that the nanny tax is complicated and can trip you up, particularly if you’re looking for a presidential appointment. Just this year, a former chairwoman of the Internal Revenue Service Oversight Board withdrew from consideration as an Obama administration appointee after reports of a nanny tax slip-up.

What’s less well known is that the tax breaks for child and dependent care are also complicated, making it easy to miss out on the full benefit you could get or to claim a break you’re not entitled to. In fact, while it got less notice than his other tax slips, Treasury Secretary Timothy Geithner improperly claimed a child care credit for sleep-away camp costs in multiple years.

Here’s a primer on how to get the most tax advantage and stay right with the law.

There are two breaks for child care costs: the child and dependent care credit, which you claim on your 1040 by attaching Form 2441, and a pre-tax dependent care account, which you can only get through your employer. You might save the most by using both of these breaks.

Fortunately, the definition of eligible child care expenses for both is the same. The child being cared for must generally be 13 or younger and neither parent can be available to watch the child full time. A single working parent qualifies. For married couples, both spouses must be employed or looking for work, unless one is disabled or a full-time student.

Costs for pre-kindergarten, before-school and after-school programs and summer day camp qualify. Private school bills in kindergarten and above, summer school and tutoring programs, and overnight camp don’t. Fees paid to a nanny agency or for a nanny you hire directly (including nanny taxes) qualify, as does money you pay to a relative who isn’t one of the child’s parents or your dependent. (For all the details, download IRS Publication 503, Child and Dependent Care Expenses at www.irs.gov.)

If your employer offers a pre-tax dependent care account (not all do) you can divert up to $5,000 per year from taxable salary to pay child care costs. (Sorry, if both spouses are offered accounts, the combined set-aside can’t exceed $5,000.) If your combined federal/state marginal tax rate is 30%, that’s $1,500 saved, at a 40% combined rate, it’s a $2,000 savings.

The child and dependent care credit is generally worth less. Poor families get a 35% credit, but that begins to phase out when a couple’s adjusted gross income hits just $15,000; families with $43,000 of AGI or more get a 20% credit against a maximum of $6,000 of expenses for two or more eligible children, or $3,000 for one. That’s a maximum savings of $1,200 for two children and $600 for one.

The result is that most families–particularly those with child care costs for just one child–save more by using a pre-tax account than just by claiming the credit.

But if you have child care costs for more than one child, you could save even more by using the credit too, points out Tara Mandel, a CPA in Wyckoff, N.J. If you have enough expenses and a tolerance for extra paperwork, you can fund the pre-tax account with the maximum $5,000 and claim the 20% credit against an additional $1,000 in expenses–but not for the same bills.

“You can get an extra $200,” Mandel says. Warning: You can’t recover unspent money from your pre-tax account or carry it over to the next year. If you’re unsure how high your bills will be, put less in the account and claim more of the credit.

What about that nanny tax? Compliance rates are notoriously low, and you may figure if you’re not looking for a presidential appointment you can ignore it. But remember, when you sign your 1040 individual tax return, you are attesting that it’s accurate. Line 60 specifically asks you to calculate any “household employment taxes.” If you have paid a nanny or other household employee more than $1,600 in 2008, you must file Schedule H, pay federal payroll taxes and issue a W-2. (For 2009, the threshold for reporting rises to $1,700.)

If your nanny asks you to withhold income taxes from her paycheck, you have to do so. Plus, you’re responsible for state unemployment taxes and, in some states, worker’s compensation coverage. There are typically quarterly state filings, and if you don’t pay quarterly federal estimates, you could face an underpayment penalty.

The result is that some families end up paying $425 to $850 a year to firms such as HomeWork Solutions in Sterling, Va., or Breedlove & Associates in Austin, Texas, which specialize in handling all the federal and state paperwork for household help. (At the higher end of fees, the firms will pay your nanny weekly, too.)

HomeWork Solutions owner Kathleen Webb happily reports that her firm has been kept busy recently filing back nanny taxes for folks in need of security clearances to join the Obama administration. “Every election cycle is a gift that keeps on giving because somebody gets tripped up,” she says.